Is Paris Hilton a savvier investor than you?

Does having a high net worth or yearly income make a person smarter? The Securities and Exchange Commission seems to think so. Following the stock market crash that preceded the Great Depression, regulators decided that individual investors needed protection from fundraisers and other capitalists offering up risky investment opportunities. They wanted to protect those who could not protect themselves, while at the same time keeping the private capital markets open for so-called sophisticated investors. And, after 50 or so years of legal wrangling, the SEC codified the concept in the form of the “accredited investor.”A person can be an accredited investor, as defined in Regulation D, Rule 501(a), in one of two ways. First, any person whose individual net worth, or joint net worth with his or her spouse, exceeds $1 million (not including the value of his or her primary residence or deducting its mortgage up to the fair market value of the residence) is an accredited investor. Second, any person who earned more than $200,000 in each of the two most recent years, or whose joint income with his or her spouse exceeded $300,000 in each of those years, and has a reasonable expectation of reaching the same level in the current year also qualifies.How does the SEC protect accredited investors? Apart from anti-fraud protections, it doesn't. The definition is designed to protect everyone else.Generally, ordinary investors are protected by mandatory disclosures that must be made to them if a private company, fund or partnership wants to offer them investment opportunities. But the burden of disclosure is far less when an investment opportunity is being offered to an accredited investor. The effect of labeling certain investors as “accredited” is that non-accredited investors are almost entirely shut out of these opportunities.The SEC's “qualified client” and “qualified purchaser” definitions further limit those who are welcome to invest in private equity funds. A “qualified client” includes a person or company (i) whose individual net worth, or joint net worth with his or her spouse, exceeds $2 million (not including or deducting the value of his or her primary residence or its mortgage) or (ii) who has at least $1 million under the management of the adviser. A “qualified purchaser” is (i) a person with at least $5 million in investments, (ii) a family business with at least $5 million in investments, (iii) a trust formed by people falling under these first two definitions or (iv) a business that has discretion over at least $25 million in investments.Although the rationales behind the “qualified client” and “qualified purchaser” definitions are not necessarily rooted in protecting the investor, the definitions still act as a barrier between investors and opportunities. A registered investment adviser is less likely to take an investment from a non-qualified client because the adviser cannot charge carried interest on that investment, and a fund that contains any non-qualified purchasers typically is limited in size to no more than 100 investors. Thus, similar to the “accredited investor” definition, these classifications exclude those investors solely on the basis of net worth and/or investments already made.If everyone (or even a majority) who met these wealth thresholds truly was sophisticated enough to have the knowledge and experience that he or she could smartly evaluate the risks of these investments, then possibly the protectionism and exclusions would achieve their goals. But the news is rife with counter-examples.Bernie Madoff's investors were “accredited” and/or “qualified,” yet they couldn't see the giant Ponzi scheme right in front of their faces. And a recent ESPN documentary detailed the myriad bad investments that have swallowed whole the massive salaries of some professional athletes. Time and again, we see that having a high net worth or yearly income does not necessarily correspond to investment savvy.The “protections” provided to all other non-accredited and/or non-qualified investors can be similarly misguided.The savviest investor in the world might not have the wealth, income or investment levels to freely choose his or her own investments. For example, the team of three 2013 Nobel Prize for Economics Laureates would need to each have at least $700,000 in preexisting net worth (or annual incomes greater than $200,000), or plan to win a Nobel prize again next year, in order for their respective shares of the $1.2 million prize money to qualify them as “accredited,” let alone as qualified clients or qualified purchasers.The SEC's accredited investor definition does both too much and too little to protect investors, and its qualified client and purchaser distinctions further limit investment opportunities solely on the basis of wealth. These definitions even fail to protect only those who could afford to take losses on a risky investment because an investor's liquidity is not factored into his or her net worth determination.However, the recently passed Jumpstart Our Business Startups (JOBS) Act will loosen some of the SEC protectionism. The SEC is expected to pass new rules in 2014 that will allow ordinary, non-accredited investors the opportunity to “crowdfund” for equity in startups through certain Internet portals. It's a small crack in at least the accredited investor scheme, but most people still will be investing in a world where a certain wealth and income grants access to special rules that other investors cannot breach — no matter how smart (or not) he or she really is.

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